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Tad Rivelle holds degrees in physics and applied math, and like many with similar training, he's found a home for his skills on Wall Street. Rivelle's specialty is bonds, which he studied first at Hotchkis and Wiley and Pimco, before co-founding MetWest, an institutional investment firm that was bought in 2009 by Los Angeles-based TCW. He now oversees more than $30 billion in mutual funds offered by TCW and MetWest, and manages the flagship
MetWest Total Return
Fund (ticker: MWTRX), a $19.5 billion portfolio with a stellar long-term track record.

Last year was an exception: The fund returned 5.52%, versus 7.84% for the Barclays Aggregate Index. This year, however, Total Return has come back swinging, with a 2.75% return in the first quarter, against a 0.5% gain in the benchmark.

Rivelle, 51, also manages the
MetWest Unconstrained Bond
Fund (MWCRX), an $18 million fund. it was launched only six months ago, with a broad mandate to seek higher returns around the world.

"The Fed has zero experience, as do most central banks, with unwinding the amount of easing and stimulus that they have injected." -- Tad Rivelle
Ian White for Barron's

Rivelle has been bearish on Treasury bonds and expects yields will be unable to keep pace with even a modest uptick in inflation. He also worries about the potential consequences of a reversal in the Federal Reserve's current interest-rate policies. Instead, he's finding value in emerging-market corporate bonds, U.S. high-yield bonds and nonagency mortgage-backed securities. Rivelle recently sat down with Barron's to offer his thoughts on today's changing fixed-income landscape.

Barron's: You have been managing bond portfolios since 1983 and have seen interest rates come down all through that time. Now the market seems to be at a turning point. What is the biggest challenge today for a bond-fund manager?

Rivelle: The issue of the day is resolving the balance-sheet recession that the U.S., Europe and other places stumbled into after the global financial crisis. Central bankers have very limited experience, as do governments, in resolving these issues, and as a consequence the markets quite rightly recognize that there is a high degree of policy risk. There are substantial uncertainties related to the potential for significantly higher rates of inflation, which is signaled in the behavior of the gold price, and the potential for slipping in the other direction, which is conveyed by the dismally low level of U.S. Treasury yields.

Is the combination of deflationary and inflationary indicators new and specific to this period of time?

In normal times, relatively modest or moderate policy errors have modest or moderate consequences. In today's environment, a moderate error of policy could have fairly extreme consequences. We just don't know. We've come full circle. At the beginning of this interest-rate cycle, which started in 1981 or '82, a typical book on investing said, "Stay out of stocks, stay out of bonds, and get into gold and real estate. Those are the only asset classes that make any sense." At the end of this long cycle, we are potentially putting ourselves at risk of ramping up the inflationary engines and going back to the world that those books were written for.

What do you think of the plan put in place in the U.S. to deal with our financial crisis?

It is the least-bad plan. It isn't a good plan, because there are no good solutions. Assets run up in the good times, so people party. And one element of partying is to load lots of leverage on the household balance sheet. Then the assets melt away, and the debt is left behind, and society has to figure out some way of dealing with it. To resolve the issue, the Federal Reserve has engineered a negative real-interest-rate environment combined with higher rates of inflation. It is trying to facilitate an adjustment process in which resources are taken from savers and handed to debtors.

Metropolitan West

Total Return Bond Fund

Sector

% of Fund

Agency MBS

27.9%

Non-Agency MBS

18.5

Investment-Grade Credit

17.0

U.S. Government

13.3

Commercial MBS

8.5

High-Yield Credit

6.1

Asset-Backed

5.6

Cash & Equivalents

1.8

Municipals

1.3

MBS = Mortgage-backed securities

Source: Company reports

What is the ongoing impact of the Fed's involvement in the fixed-income markets?

Treasuries are the asset class that is bearing the brunt of direct intervention by the Fed via all its policies—quantitative easing, the zero rates, Operation Twist, and so forth. The Fed is engaged in a kind of fictional narrative with the marketplace, in which it is expressing the idea that it is engaged in strong-dollar policies. It hasn't relaxed its vigilance against inflation, and yet, all the same, we are living in a world of disequilibrium, in which Treasury rates are below the rate of inflation. It is not a feasible place for any asset class to be, long-term.

More and more, investors are recognizing that in order to maintain their income levels, they are being forced into riskier asset classes. The Fed is smiling as this process is unfolding, although in fairness it is also reducing the risk level associated with these riskier asset classes by engaging in a reflationist approach.

What are your favorite fixed-income sectors?

More or less in order of attractiveness, we like non-agency mortgages for U.S.-dollar fixed income. This is still a dislocated asset class. It is fairly complicated to analyze, and you need an appropriate set of tools with which to do it, or a manager to invest with who has the skill set.

We estimate there is still 8% to 11% of loss-adjusted yield in much of this asset class, and it hasn't come close to being fully remediated.

Second, we like emerging-market corporate debt for the strength of the fundamentals in emerging-market economies, the relatively rapid rates of growth and the relatively low levels of leverage, particularly compared with developed markets. The third asset class is U.S. high-yield. There is a common correlate to these three asset classes: None of them is positively correlated in any strong way with U.S. Treasuries.

Do you own any Treasuries now?

We do, though the amount varies according to the mandate of the fund. Where we are given latitude to invest in Treasuries, we are keeping the smallest allocation we can. It is a low number these days, probably the lowest in our history

It seems like the Fed has boxed itself in on interest rates. How will it reverse-engineer its process of lowering rates to near-zero without a disastrous impact on the Treasury market?

The Fed has zero experience, as do most central banks, with unwinding the amount of easing and stimulus that they have injected. To the extent that history is a guide, we would have to look at the early 1990s, when there was a similar belief that elements of a balance-sheet recession were left over from the 1980s. It was nothing as severe as what we have experienced most recently, and the Fed was on hold for a long time. They got down to 3% rates, and in May 1993, [former Federal Reserve Chairman Alan] Greenspan stood in front of Congress and said, "The secular head winds are dissipating." That was meant to alert audiences that the Fed was getting ready to unwind its stimulus. Nobody listened, as you might expect.

Six months later,
Coca-ColaKO 2.8184480234260616%Coca-Cola Co.U.S.: NYSEUSD42.135
1.1552.8184480234260616%
/Date(1481309153045-0600)/
Volume (Delayed 15m)
:
15689533
P/E Ratio
25.545454545454547Market Cap
176745057205.372
Dividend Yield
3.3214709371293% Rev. per Employee
341469More quote details and news »KOinYour ValueYour ChangeShort position
[ticker: KO] issued 100-year bonds, an almost unprecedented thing. And a few months after that, in February 1994, the Fed took a baby step, raising rates to 3.25%, from 3%. So from May '93 to February '94, a relatively compressed time frame, you got 25 basis points [one-fourth of a percentage point] of tightening. That tiny step unleashed the most severe bear market in Treasuries in decades.

No one knows if that is going to unfold here, but it seems hard to understand how, when the Fed decides to exit its current policy, it won't be a messy process. I don't know how the Fed is possibly going to contain the market forces that it has suppressed all these years.

You spent some time in some European financial centers recently. What was your take-away, and what is your outlook for the euro zone?

There is a high level of commitment on the part of all the governments to save the euro and see the ultimate success of the European [Union] experiment. Where there is a gigantic difference of opinion is where all of the interesting issues arise, from an investment standpoint. The fundamental problem of Europe is that it is one currency, but many systems. The differences between the economic models of Germany versus, say, Italy and Spain, are too extreme to bridge in the near term. As a result, the view from the north, and primarily Germany, is: You guys have to redesign your labor markets and tax systems and fiscal policies, and you have to make them more German. If you do that, you will derive all of the benefits that we in Germany derived through our structural reform. There will be more productivity, more wealth, more growth, and your people will have more choices.

The view from the south is, if we could wave a magic wand and fix things, we would, but we can't. We exist in a democracy, and there are limitations to how rapidly these changes can be implemented. If you don't give us enough help here, we are never going to get to the finish line, for the simple reason that our electorates will rebel and abort steps in the direction of structural reform.

How do investors navigate the contradiction?

Investor can't look at Europe and say there is a coherent plan to get out of the euro zone's balance-sheet recession. We will see recurrent events that may rise to the level of crises, or perhaps not, and that will be addressed by one-time solutions that will make things better.

What percentage of your portfolio is invested in European bonds?

Our holdings are limited. European bonds don't really fit inside a value manager's wheelhouse because what you're evaluating with them is the overall sentiment of the market. To the extent that Italy loses the confidence of the market, there is a risk that, even though the country might be fundamentally sound and solvent, things can unwind in ways that can't be foreseen. There is so much volatility that comes with the package that there are better ways to take advantage of what is happening in Europe.

And what are they?

Bonds of U.S. money-center banks are one of the best places to go. The banks were put under a steamroller last fall, and their bonds moved largelyin sentiment with conditions in Europe.

To what degree should fixed-income investors be looking to emerging markets to enhance yield?

Emerging markets are where the growth is, where balance sheets are strong, and where fiscal conditions of governments are good.

The MetWest Unconstrained Bond Fund was launched auspiciously last fall, when many asset classes were out of favor. Consequently, it has produced some strong results. Emerging markets are about 14% of the portfolio, but it is a small fund, so we're only talking about $2.4 million or so.

The fund's largest EM holding is
Banco do Brasil
[BDORY] 10-year paper with triple-B ratings, yielding 5.5%. This is the largest bank in South America.

Have the rules of fixed-income investing changed in the course of your career?

Investment cycles, in many cases, probably exceed our lifespan. The one thing you can say is that the busts are created by the booms.

The stress is manufactured during the good times. Being a good full-cycle investor means recognizing that fundamental errors of judgment are inherent in the human condition, and those mistakes are getting made at every moment in time.

Is this the end of a long secular bull market for bonds, and if so, what will be the long-term fallout?

It is, in the sense that we have pushed the model of growth that existed for the past 30 years absolutely as far as it can go. Take it with a grain of salt, but one of the points Alan Greenspan made was that, as the emerging markets came along and prospered, they built pools of savings that couldn't be accommodated because there was a lack of a property rights and capital-markets structure domestically. So capital was flying out of these fast-growing countries and flooded into first-world markets. That changed credit standards and distorted our markets. That process is probably done for now.

What is the role of a bond-fund manager when the party ends?

The foremost role of a bond-fund manager always is to protect capital, to keep himself and his clients out of trouble. It is going to get miserable at some point. There will be a rising-rate environment, with people flying headlong out of a variety of asset classes. The circumstances are always different, but that is always the case.